If the stock goes up beyond $20.60, the option can get called and you deliver your shares at $20, pocketing $2,000. You just made $260, or 15%. The stock could do anything, but you can’t possibly lose your shirt selling this covered call. In fact, if the stock goes to zero, you’ll cash out better than most by keeping the $60 premium (while everyone else loses 100% of their money).

Kurt’s strategy tells you to buy puts. In that case, you would buy the one-month put at $15.00 and shell out another $0.30 x 100, or $30.00. Now, your investment is $1,830. If the stock continues to drop, the markets are offering you a chance to buy a great business at a lower price, but you’re already in a contract to sell that business at $15. If the stock never hits that $15 mark, you’ve wasted $30. If it does hit that price and your shares are taken, you have to buy the wonderful business again.

Kurt seems to be an options trader, looking to profit from every move in the markets. I’m not. Instead, I am simply trying to capitalize on peoples’ fear and greed. Buying at $18 and watching the price drop to $14 is not scary to me — it’s an opportunity; I see no need to %u201Cprotect%u201D a portfolio against opportunities.

Make sense?

There is a nice article I read at: http://www.radioactivetra…

This guy lost his shirt on the CC strategy.

The bottom line is, first protect your investment, then write the CC.

A better way is to buy a PUT immediately with the purchase of the stock, and then write CC on 50-70% (depending on the outlook and risk level) of the holing to reduce the cost of the PUT. This will keep the downside protected, and still have the upside potential.

Note: I am just an individual investor/trader and no interest with any of the website mentioned, just trying to bring a perspective.

Sounds like one needs to look at the premium and make a decision – but that there is a bit more voodoo/subjectivity in deciding whether to buy options vs deciding whether a company is selling at a huge discount.

In this case, the markets were high in my opinion. I did it again over the past few months when the Dow would hit around 13,000. I don’t try to predict the markets per se, but I do know when I think they are overpriced in the real short term. I saw no reason for the Dow at 13,000 last week, so I would have felt comfortable selling a call. If the Dow were to hit 12,000 this week, I wouldn’t be selling calls.

Though I don’t try to predict the markets, I will use them to help me decide whether or not people are happy and if I should consider selling calls. If you see an option opportunity jump out at you, take it. If not, relax a bit.

Having just written my first calls, I’m very interested in how to decide when a premium merits writing a call. Most of the stocks I’ve been looking at have a small premium for, say, a month out. I’ll throw a few numbers up:

My initial purchase: $10K

Price: ~$33/share

Shares: 300

So I could write 3 calls for $35, a month out. Say that the premium is .5, so I would make $150 – commission: ~1.3%*. The other choices are to buy farther out, and reduce commissions (since I only have to buy once – but usually the premium seems a bit lower) or to buy higher and also reduce commissions, often to pretty low (e.g., $40 a month out means a .15 premium, netting me a pretty measly $45 – commission = ~.3%*)

*(monthly)

How do you make the decision? If I’m buying the stock, obviously I think it will go up at some point, so how do I decide what cushion to leave the price before my stock might get called? In this case $35 leaves me a 6% upside 1.3%premium. $40 leaves me more upside, but way less premium… Seems like gambling.

Another possibility – wait a bit and see if the price increases and then write a call on that higher price, increasing my premium a bit.

Sincerely,

Call me Confused

I sold 3 covered calls for March strike 25, for $1.20/share. My cost basis in AEO is now $20.80/share. I made this transaction for two reasons..

1. If I am forced to sell AEO at 25 (so if it reaches 26.2), I have made a ~20% gain since I’ve held it. Which satisfies me. I will then have to cash to engage in a workout or two I have my eyes on.

2. I can make some change buying back the options if there is some random thing that makes everyone sell off their AEO.

Is my reasoning sound? Anyone have an opinion?

The second piece of good news is that I am looking for a brilliant member of the board to check my math on another round of market and AEO analysis.

A couple of nights back, I downloaded the data for the S&P 500, intent on duplicating / accepting or rejecting Ken Fisherâ??s comparative analysis of stock yields and bond yields from a couple of years ago. If stock yields (earnings divided by price) are more than a percentage point or two greater than bonds, then prime-grade corporate bonds (which follow government bonds at a small premium) represent a cheap form of financing corporate growth and expansion. Historically, this spread has predicted economic and market booms in the US and other first world countries, as well.

So, here is what I did, along with the math:

The weighted average forward PE for the S&P 500 as of Tuesday’s close was 14.02. This puts the equity yield at 7.13 percent (100 / 14.04 = 7.13). The 10-year bond yield came in at 4.07 percent (an un-adjusted PE equivalent of (100 / 4.07 = 24.57). Adjust for a conservative 25-percent tax rate (corporate rates normally approach 40 percent), and the bond’s comparative value is roughly 3 percent [4.07 x (1 - .25) = 3.05].

In other words, returns from the stock market exceed the risk free cost of capital by 4 percent (3 percent if not adjusted for tax differences). To achieve parity, the average market PE would need to rise from 14.02 to 24.57 — through, either, an increase in price or a decrease in earnings to close this spread [100 / 4.07 = 24.57].

So, let’s assume the worst case scenario — prices stay at current levels and earnings decline under a weakening market. Check my math, but I believe earnings would need to drop by between 42.7 percent and 57 percent [7.13 x X = 4.07, 4.07 / 7.13 = 57.06 percent on the high end and 7.13 x X = 3.05, 3.05 / 7.13 = 42.8 percent on the low end]. While stock market corrections, by definition, require a decline of 10 percent and bear markets require a 20 percent decline, I don’t believe the market will drop by more than 42 percent or, worse, more than 50 percent. Why? The Yen carry trade works in both directions â?? i.e., US corporations can finance debt in Yen â?¦ [raising the question of why the US government isnâ??t doing the same thing (China is buying US bonds), but that is another matter]. I also don’t believe it because the ’87 crash dropped the market by roughly 23 percent … in one depressing and alarming day.

Regardless of the market, AEO is currently selling at more than a 60 percent discount if expecting its 10-year growth rate to drop by more than a third. In other words, such a market crash seems priced in the stock value at this level. Even if projecting that AEO will post 0.00 percent growth over the next decade and just 5 percent from years 11-to-20, AEOâ??s intrinsic value is $21.49 (by DCF model, applying a 15 percent discount rate) â?? 3 cents lower than yesterdayâ??s closing price.

Now, the short argument is that the dollar is going to hell, the market is falling, government debt is high, a recession is coming, and inflation is growing. The worst short prediction Iâ??ve seen is for a deep recession â?? not a market crash and depression. None are arguing that the market is a speculative bubble with a forward PE of 14. So, the question naturally becomes one of why is AEO so overvalued that it has a lot further to fall, what is it about the economy that isnâ??t already priced into the stock, and / or are there any false assumptions or miscalculations in my model?

Full disclosure, following Joe’s posting, I performed this analysis and posted it on the Yahoo discussion board — where a rabid group of shorts once congregated. None was able to attack this, which proves just one thing. Namely, most shorts, like longs, are playing momentum rather than fundamentals. But that should be saved for a different discussion.

Rickey (November 12, 2007 at 2:26 PM) is correct. Furthermore, at any time JNJ is over $65 you could get assigned and have to sell your shares at $65. Early assignment sometimes occurs just before an ex-dividend date.

That is the downside, that I give up gains because the stock takes off and I don’t own it because I won’t get put to. Still, it is a conservative strategy and keeps me from jumping in too soon because I get that “don’t want to miss out feeling.”

What I also do is once I have my position, if the stock hasn’t moved, I’ll write puts again. If I get put to I write covered calls. I repeat till the stock moves away from my entry position and I am left with the number of shares I want to have and all the put and call premiums. Of course I have to be comfortable with having a larger position for a time than I originally planned.

I write covered calls only on those stocks whoese IV , i cannot estimate properly, but are good stocks. Recently, I wrote CC on NSTR. Its a medical device company trying to get PMA for its Investigational device for stroke recovery. One reason, the premuim was high. Second reason, Its tough for me to value the stock, there are no earnings , no assets, only promises.

I differ on the idea “Don’t sell puts”. If you are a good stock picker, writing puts is the best strategy to buy the stock at a lower cost base. Writing puts is no way more dangerous than buying the stock outright. You CANNOT prove otherwise.;try it.